Why Do Banks Reward their Customers to Use their Credit Cards?

54 Pages·2010·0.24 MB·English

by  Sumit Agarwal

Why Do Banks Reward their
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Sumit Agarwal, Sujit Chakravorti, and
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December 20, 2010
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F WP 2010-19
Why Do Banks Reward their Customers to Use their Credit Cards?

Sumit Agarwal, Sujit Chakravorti, and Anna Lunnα
December 20, 2010

Abstract
Using a unique administrative level dataset from a large and diverse U.S. financial institution, we
test the impact of rewards on credit card spending and debt. Specifically, we study the impact of
1 percent cash-back reward on individuals before and during their enrollment in the program. We
find that the marginal increase in spending per month during the first quarter of the program is
$68. Average monthly payments decreased more than the marginal increase from cash-back
rewards resulting in card debt increasing an average of $115 during the first quarter. Evidence
from the credit bureaus confirms that consumers offset their increased spending and debt on their
rewards card by lowering their spending and debt on their other credit cards. Segmenting the
data by different types of cardholders, we find that cardholders who do not use their card prior to
the cash-back program increase their spending and debt more than cardholders with debt prior to
the cash-back program. We also find heterogeneous responses by demographic and credit
constraint characteristics.

Key Words: Household Finance, Credit Cards, Consumption, Financial Incentives, Rewards
JEL Codes: D1, D8, G2

The authors would like to thank Gene Amromin, Marc Bourreau, Rich Rosen, Marianne Verdier and seminar
participants at the Federal Reserve Bank of Chicago and the University of Paris Ouest Nanterre la Défense for
helpful comments and suggestions. The views expressed in this research are those of the authors and do not
necessarily represent the policies or positions of the Federal Reserve Board or the Federal Reserve Bank of Chicago.
αAll three authors work in the Economic Research Department of the Federal Reserve Bank of Chicago and can be
reached at: [email protected], [email protected], and [email protected], respectively
1. Introduction
Today, rewards are routinely given by airlines, hotel operators, and credit card issuers to
increase use of their products. In the case of credit cards, rewards are an effective way to attract
cardholders or convince existing ones to use a specific card for their purchases and borrowing
needs. In 2005, six billion reward card offers were mailed by the credit card industry. Typically
these mailing are randomized and the response rates are very low. For instance, in 2005, the
response rate was 0.3% (also see Agarwal, Chomsisengphet, and Liu, 2010). Card companies
have pursued aggressive tactics, such as offering cash back, airlines miles, rebates and lower
interest rates. The main objective of the card companies is to increase card spending that may
result in cardholder’s debt in the future.1
In this paper, we study the impact of credit card rewards on spending and debt. We
explore three questions. First, do consumers spend more when given rewards? Second, do
consumers increase their debt because they receive rewards? Third, do consumers partially or
fully offset their increases in spending and debt accumulation by reducing spending and debt on
their other credit cards?
We find that consumers generally spend more and increase their debt when offered one
percent cash-back rewards. The impact of a relatively small reward generates large spending and
debt accumulation. On average, each cardholder receives $25 in cash-back rewards during our
sample period. We find that average spending increases by $68 per month and average debt
increases by over $115 per month in the first quarter after the cash-back reward program starts.
The greater increase in debt compared to spending suggests that average monthly payment drops
more than the marginal increase in spending from the cash-back program. Specifically, we find a

1 Many websites offer tips to smartly choose the rewards programs. For example, www.rewardcreditcardsite.com
suggests the following 7 tips – do not carry a balance, know what “UP TO” means, what the limit, etc.

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reduction of payments within the first quarter of $38 of the start of the program, suggesting that
the marginal increase in spending due to the cash-back reward is converted into debt along with a
portion of baseline spending. Furthermore, evidence from credit bureau data confirms that
consumers substitute their spending from other cards to the card with cash-back and decrease
debt on their other cards. Finally, even in the long run, we find a persistent increase in spending
and debt. Specifically, the average spending and debt rise during the nine months subsequent to
the cash back reward is $76 and $197 per month, respectively. The reduction in payments is $83
during the same nine months period.
We identify certain types of cardholders that are more responsive to the cash-back
rewards program. Cardholders that do not carry debt have a larger response to the cash-back
program. We find that 11 percent of inactive cardholders during the three months prior to the
cash-back program used their cards to make purchases of at least $50 in the first month of the
program. Specifically, inactive cardholders increase their average per month spending by $220
during the first quarter and their average per month spending only decreases to $180 during the
first nine months. Their average per month increase in debt during the first quarter is $167. We
find that these cardholders substitute spending and debt accumulation from other cards to the
cash-back card.
Cardholders react differently to cash-back rewards based on some demographic
characteristics. Average per month spending increases by $55 by single cardholders and by $95
by married cardholders during the first quarter. Similarly, single cardholders increase their
average per month debt by $65 as compared to $111 by married cardholders during the first
quarter. We do not find significant differences between male and female cardholders.
Cardholders that earn less than $40,000 increase their average per month spending by $47 as
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compared to $74 for cardholders that earn more than $40,000 during the first quarter of the
program. Those earning below $40,000 accumulate $56 additional debt on average per month
versus $87 for cardholders earning more than $40,000 during the first quarter.
Credit constraints also impact the response to the cash-back program. Not surprisingly,
those cardholders with higher credit limits tend to spend more and accumulate more debt per
month on average in response to the cash-back program. Cardholders utilizing less than 50%
utilization of their credit limits tend to spend more and accumulate more debt per month.
We are also able to study another tool to increase card usage and debt, albeit more costly,
to convince cardholders to increase their debt: APR reductions. During our sample period, the
financial institution offered certain cardholders a 10 percent APR reduction. Consistent with
Gross and Souleles (2002), we find that consumers react to such a large reduction in APRs by
increasing card spending and debt. However, we find that only part of this increase in spending
contributes to an increase in the consumer’s balance for all her credit cards, which suggests that
consumers shift spending and debt from other cards.
Our paper incorporates key features from several strands of the literature in economics
and finance – consumer payment choice, consumption response to income shocks, and
behavioral finance. We tie our work to each of these fields and highlight our contribution. First,
the literature on payment substitution argues that monetary incentives are effective in enticing
consumers to use a given payment instrument over another. While the literature focuses on
different types of payment instruments, our analysis suggests that these incentives are also
effective in differentiating providers of the same type of payment instrument. Second, we
incorporate findings from the consumption literature that study monetary payouts such as tax
rebates and their impact on increased spending and debt. Our results confirm one of the main
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findings in this literature that only a small financial incentive is required to change consumer
behavior. Third, the literature on time-inconsistency suggests that at least some consumers
increase their spending and debt when offered financial rewards but may incur greater debt than
expected. Given our ability to study a cardholder’s overall portfolio, we are able to distinguish
between increase in spending and debt on a specific card and how that affects a consumer’s
overall balance sheet.
In addition, our results also have policy implications. For instance, the recent regulatory
and legislative actions have focused attention on the impact of rewards on consumer choice of
payment instrument and who pays for these rewards. Some observers have argued that the
recently passed Card Act and recent changes to overdraft access for debit cards in the United
States would reduce the ability of issuers to extend rewards.2 While mandated reduction in
cardholder fees and finance charges may potentially affect the level of rewards, we find that
rewards have significant impact on credit card debt especially via substitution from another
issuer’s credit card suggesting that rewards are an effective tool to steal customers from a
financial institution’s competitors.
The rest of the paper is organized as follows. Section 2, reviews the literature. Sections
3 and 4 outline the data and provide results, respectively. Finally, section 5 concludes.

2. Background
During the past decade, there has been a growing literature documenting the changing
nature of consumer finance due to the explosive growth of credit card usage. For instance, in
1970, credit card related consumer debt totaled $2 billion as compared to $626 billion in 2000.

2 For details about the 2010 Card Act, see http://www.federalreserve.gov/consumerinfo/wyntk_creditcardrules.htm.
For details regarding recent debit card overdraft rules, see
http://www.federalreserve.gov/consumerinfo/wyntk_overdraft.htm.
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In 2007, servicing credit card debt (interest plus minimum payments) represented about 14% of
disposable personal income. According to Kennickell, Mach, Bucks and Moore (2009), 29
percent of households with a percentile net worth less than 20 percent carry credit card debt, as
compared to 38 percent of household with a percentile net worth above 90 percent carry debt.
Credit cards serve two main purposes. First, they serve as a payment device in place of cash or
checks for millions of routine transactions. Most credit cards have a grace period whereby
interest charges can be avoided by paying off the outstanding balance in full at the end of the
month. Second, they are the primary source of unsecured open-end revolving consumer credit,
competing with bank loans and other forms of financing.3
The theoretical payment card literature focuses on how the costs of payment cards are
distributed between banks, merchants and card holders through prices. These models generally
conclude that banks may charge fees in excess of their costs to merchants and extend incentives
to cardholders to increase card adoption and usage (Baxter, 1983; Chakravorti, 2010; Rochet and
Tirole, 2002). These models focus on adoption and usage of payment cards vis-à-vis other
payment instruments. The results are dependent on various model parameters including the
degree of competitiveness in the market for goods and payment services along with consumer
and merchant demand elasticities. For the most part, this literature does not focus the extension
of credit.4
Debate continues as to who pays for credit card rewards and their social welfare
implications. Some U.S. merchants have complained that financial institutions are funding their
credit card rewards by extracting merchant surplus (Jacob, Jankowski, and Lunn, 2009).
Theoretical models focus on other funding sources for credit cards rewards. For example,

3 There are other payment instruments that share these characteristics, e.g. checks and debit cards with overdraft
protections. For more discussion about linkages between consumer payment and credit, see Chakravorti (2007).
4 Bolt and Chakravorti (2008), Chakravorti and To (2007), and Rochet and Wright (2010) are notable exceptions.
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Chakravorti and Emmons (2003) argue that rewards are funded by those that borrow in the form
of higher interest rates. More recently, Schuh, Shy, and Stavins (2010) argue that cash users
subsidize these rewards because merchants are unable to separate credit card users from other
payment instrument users by charging more to credit card users.5
There is anecdotal evidence from merchants suggesting that rewards are effective in
convincing consumers to substitute credit cards for debit cards to reduce their payment costs.
IKEA, a large furniture store operating in several countries, imposed a 70 pence surcharge on
credit card transactions in their United Kingdom stores resulting in a 15% decrease in credit card
usage (Bolt et. al, 2010). Given the relatively high average transaction size at IKEA, only a
relatively small financial incentive was required to change consumer behavior.
Some policymakers have intervened in the pricing of payment services to reduce
consumer incentives to use their credit cards to make purchases especially when consumers do
not avail the extension of credit. The Reserve Bank of Australia (RBA) argued that credit card
rewards partially funded by fees charged to merchants distorted the efficient choice of payment
instruments by consumers. The RBA (2008) estimated the benefit to consumer of using their
credit cards as purely a payment device as AUS$ 1.30 for each AUS$ 100 spent. To reduce the
incentive for consumers to use credit cards, the RBA mandated around a 50 percent reduction in
the interchange fee (fees paid by merchants’ financial institutions to issuers that are paid for by
merchants) along with other policy changes.
Several empirical studies use consumer surveys to study the impact of rewards on
payment instrument usage (Ching and Hayashi, 2010). Borzekowski, Kiser and Ahmed (2008)

5 In some cases, merchants are unable to charge different prices based on the type of payment instrument to make
purchases. However, in cases where merchants have the ability to do so, few merchants actually set different prices.
Regardless of the reason, one-price policies may result in cross-subsidies between users of different payment
instruments.
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examine survey data on debit card usage and find that financial incentives are effective in
steering customers to one payment type. Twenty-one percent of survey respondents cited
pecuniary reasons for substituting between payment types, and many in this group explicitly
cited credit card rewards. Zinman (2009) also observes consumer price sensitivity to payment
choices. Specifically, he finds that credit card users with balances are more likely to use their
debit card because interest accrues immediately after credit card purchases are made. Our paper
is the first to empirically test the effect of credit card rewards not only on payment choice but on
change in spending and debt.
The consumption literature considers permanent and transitory shocks to consumption.
Giving consumers cash rewards for spending using a certain device increases their consumption
because they are receiving money for purchases that they would have made without the
incentives. A number of papers have studied consumers' response to a permanent predictable
change in income, as a means of testing whether households smooth consumption as predicted
by the rational expectation life-cycle permanent-income hypothesis. Using credit card data,
Gross and Souleles (2002) find a marginal propensity to consume of 13% and for accounts that
had an increase in credit limit. They also find that debt levels rise by as much as $350. Souleles
(1999) finds that consumption responds significantly to the federal income tax refunds that most
taxpayers receive each spring. Both of these papers find evidence of liquidity constraints.6  
Aaronson, Agarwal, and French (2007) find that following a minimum wage hike, households
with minimum wage workers often buy vehicles. The size, timing, persistence, composition, and
distribution of the spending response is inconsistent with the basic certainty equivalent life cycle
model.

6 Other related studies include Wilcox (1989, 1990), Parker (1999), Souleles (2000, 2002), Browning and Collado
(2001), Hsieh (2003), and Stephens (2003).
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There have been four recent studies, using micro data, by Shapiro and Slemrod (2003a
and 2003b), Johnson, Parker, and Souleles (2006) and Agarwal, Liu, and Souleles (2007) on the
2001 tax rebates. Given the conflicting findings of the consumption literature, we cannot form a
hypothesis about whether consumption will increase in response to these cash rewards.
Moreover, our case becomes more complicated when we consider the relationship between the
rewards and spending. While a consumer may receive cash for transferring all their spending
from their debit card to this credit card, she also has an incentive to increase her spending and
use the credit line attached to the credit card. Therefore, we look to the behavioral literature to
find predictions about how a reward program will affect consumers’ overall debt level.
The seminal paper on time inconsistency is Ausubel (1991) who finds that consumers
often ignore the interest rate on credit cards because when they make purchases they fully intend
to pay back but change their mind when the bill comes. Agarwal, Chomsisengphet, Liu and
Souleles (2006) find that consumers both under- and over-estimate their spending on the card.
More recently, behavioral economists have extended this time inconsistency feature in several
directions (Heidhues and Köszegi, 2010). Laibson (1997) argues that consumer have self-control
problems discounting present consumption over future consumption, describing it as “hyperbolic
discounting.” This provides an explanation for the first anomaly – increased spending. A
potential explanation for the second anomaly – increased debt, can be explained by the “bounded
rationality” model of Gabaix and Laibson (2000). It is conceivable that the contract terms and
conditions are rather complex and over time consumers forget them and use the credit card for
present consumption. Ex-post consumers could even justify their mistake as financially
insignificant or easily fixable since they receive several balance transfer offers on a weekly basis.
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